This is an update of our article of 19 June 2019 to advise that the reflective loss rule no longer applies to claims by creditors, following the Supreme Court's ruling on 15 July 2020 to reverse the Court of Appeal's decision on the cited Marex case.
Acquiring shares in a company is inevitably accompanied by a degree of risk. Volatile markets can often drastically impact upon the value of a company's shares, leaving shareholders elated or, alternatively, sorely disappointed.
Another reason for the fluctuation in value of a company's shares is the actions and decisions of management, i.e. the directors. For example, shareholders suffer financial loss in circumstances where a director has breached his or her fiduciary duties and caused loss to a company, thereby spiralling its share value downwards and reducing dividends.
In these circumstances shareholders will often want to know what tools are available to them to try and recover compensation for their loss. The subtle distinction between what is the company's loss and what is the shareholder's loss can often cause confusion. Enter the rule of reflective loss.
The rule of reflective loss
The rule of reflective loss emerged in the early 1980s in the case of Prudential Assurance v Newman Industries (No. 2)  1 Ch 204, and prevents claims by shareholders where their loss merely reflects the loss suffered by the company.
Where a company suffers a loss caused by a breach of duty owed to it, only the company may sue in respect of that loss. It follows that a shareholder is generally not able to bring a claim in respect of that loss as it belongs to the company. The rule was helpfully explained in Prudential as follows:
'…what [the shareholder] cannot do is to recover damages merely because the company in which he is interested has suffered damage. He cannot recover a sum equal to the diminution in the market value of his shares, or equal to the likely diminution in dividend, because such a "loss" is merely a reflection of the loss suffered by the company.
The shareholder does not suffer any personal loss. His only "loss" is through the company, in the diminution in the value of the net assets of the company, in which he has (say) a 3 per cent. shareholding. The plaintiff's shares are merely a right of participation in the company on the terms of the articles of association. The shares themselves, his right of participation, are not directly affected by the wrongdoing. The plaintiff still holds all the shares as his own absolutely unencumbered property. The deceit practised upon the plaintiff does not affect the shares; it merely enables the defendant to rob the company.'
The Royal Court of Jersey confirmed that the rule of reflective loss is part of Jersey law in Freeman v Ansbacher  JLR 1 (Freeman). The rule has been extended over time to not only include a diminution in share value but also reduced dividends and other payments which the shareholder might have been entitled to, had the company not suffered loss.
There are limited exceptions to the rule of reflective loss (discussed below), but the news that only the company can bring a claim is generally not well received by shareholders. However, the rule is underpinned by sound reasoning, as follows:
- There could be double recovery, were the company and a shareholder both able to claim against the wrongdoer;
- If the company chooses not to claim against the wrongdoer, the loss to the shareholder is caused by the company's decision, not by the wrongdoer;
- There are public policy considerations surrounding the company and the shareholder having divisible rights as the company might be discouraged from entering into settlements; and
- There is a need to preserve company autonomy and avoid prejudice to minority shareholders or other creditors.
Discretionary trust assets
It is worth noting that in Freeman, the Royal Court distinguished between a claim brought by a shareholder of a company and a claim by a beneficiary of a discretionary trust in respect of alleged mismanagement of a company which is wholly owned by the trust. In the latter scenario, the Royal Court held that it was strongly arguable that the reflective loss principle would not apply because:
- a discretionary beneficiary has no direct entitlement to trust assets, they can only seek reconstitution of the trust fund;
- the reconstitution of the trust fund would mean that no loss would have then been suffered and there could be no ‘double recovery’;
- it is often the case that the directors of the wholly owned company will be the very same employees of the corporate trustee in Jersey who are responsible for administering the affairs of the trust. The directors do not owe a duty to the beneficiaries and the trustee cannot sue the directors. The only entity that can sue the directors is the wholly owned company; and
- the Royal Court recognised that until there is a change of trustee, it seems unlikely that the corporate trustee would cause the company to sue its directors, who are the persons employed by the corporate trustee to administer the affairs of the trust and to act as directors of the company.
In Sevilleja v Marex Financial Ltd (Marex), the English Court of Appeal had to tackle whether the rule of reflective loss extended to non-shareholder creditors of a company and concluded that it did. The basis for this decision is that the rule would apply to a shareholder who was also a creditor of the company, so there is no logical reason why it should not apply to a non-shareholder creditor. The creditor would not be able to bring a claim which belonged to the company.
However, the Supreme Court has now unanimously overturned the Court of Appeal’s decision. The reflective loss principle no longer applies to claims by creditors (whether they are also shareholders or not).
Notably, the Supreme Court held that the rule of reflective loss had become difficult to confine and 'had the potential to have a significant impact on the law and on commercial life'. The rule was also likened to 'some ghastly legal Japanese knotweed'. Indeed, three of the seven Supreme Court judges were in favour of abolishing the rule entirely.
While the Supreme Court’s decision will be a breath of fresh air for creditors, the outlook for aggrieved shareholders is not all negative. Shareholders can still look to the well-established pathways of:
- an unfair prejudice claim under the Companies (Jersey) Law 1991 (as amended) (the Companies Law);
- a common law derivative claim; or
- an application to wind up the company under the Companies Law.
An unfair prejudice claim is geared towards the mismanagement of a company whereas a derivative claim is aimed at misconduct. This is an important distinction to draw when deciding which claim is suitable. We have summarised these two claims below, although they warrant their own individual guides.
The winding up of a company is, typically, very much the last resort but can also be used strategically to place pressure on the company.
The unfair prejudice regime in Jersey is broadly similar to that in England and Wales. If the shareholder is of the view that the company's affairs are being conducted in a way which is unfairly prejudicial to the interests of all or some of the shareholders, the aggrieved shareholder can apply to the Royal Court for a wide range of orders which, by way of example:
- regulate the conduct of the company;
- refrain the company from taking certain steps or require the company to take certain steps;
- authorise proceedings to be brought in the name and on behalf of the company; and
- require the purchase of the aggrieved shareholder's shares (at a fair value) by other shareholders or by the company itself.
A derivative claim is a claim made by a shareholder on behalf of the company and for the benefit of the company. Consequently, to the extent that the company recovers funds, the company will benefit whereas the shareholder could be liable for the costs and expenses of the proceedings unless an arrangement with the company is entered into.
In summary, a derivative claim will only be available where:
- the act complained of is unlawful;
- the act complained of amounts to a fraud against the minority; and
- the wrongdoers control the company.
The permission of the Royal Court is required to bring a derivative claim. The above legal thresholds must be met and, importantly, there must be no other remedy available. Derivative claims are less common as a result of these legal hurdles.
An aggrieved shareholder can apply to wind up the company on a 'just and equitable' basis under the Companies Law which will result in the end of the life of the company.
The Royal Court has said that the words 'just and equitable' must be given a wide and flexible interpretation, so it is not possible to give an exhaustive list of circumstances in which it will order a company to be wound up on such grounds. However, one of these grounds is a justifiable loss of confidence in the management of a company due to fraud, dishonesty or serious mismanagement of the company's business by the directors or majority shareholders.
If a winding-up order is made, a liquidator will be appointed to manage and wind up the company. The liquidator's fees and expenses will be paid in priority to any other claim from the assets of the company. The liquidator will then seek to realise the remainder of the assets of the company prioritising the company's creditors first and its shareholders second.
In light of the above, an application to wind up the company can be considered to be the 'nuclear' option and therefore requires careful consideration before deployment.
Read our guide which looks at the key things you need to know about winding up a company on just and equitable grounds here.
Jersey is a reputable and highly regulated financial centre. It has a sophisticated, responsive and modern legal framework and has consistently demonstrated a willingness to assist aggrieved shareholders where it is possible to do so.
The Supreme Court’s decision in Marex provides a welcome reminder of the principles underlying the rule on reflective loss and has removed the restrictions previously placed on the creditors of a company. However, aggrieved shareholders still have a number of options available to them inspite of the rule.